The Economy Has Nothing To Do With The Stock Markets, Right?

One of the first financial guys I ever met told me confidently “the economy and the markets have nothing to do with one another.” Recently I was interviewing potential new writers for a financial newsletter, which I’ve been asked to help launch, and one of them (a professor of economics) told me that “the financial markets and the economy are two different beasts entirely.” Where do people get such ideas?

One place they got them is from John Maynard Keynes who saw the movements of financial markets as being like a gigantic casino, moving randomly in response to people’s animal spirits which he believed were throwbacks to our animalistic instinctual forebears. His intellectual grandson Harry Markowitz applied that basic idea with more mathematical rigor while creating Modern Portfolio Theory, which Markowitz said was different from classical economics because it ignores supply and demand; in other words, the underlying economy.

First let’s look at the master. Here’s my friend Mark Skousen in his excellent book The Making of Modern Economics on the irrationalist stream in Keynes and his compulsion to sever economics from finance:

“Keynes complained of the irrational short-term ‘animal spirits’ of speculators who dump stocks in favor of liquidity during such crises. Such ‘waves of irrational psychology’ could do much damage to long-term expectations, he said. ‘Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate resources upon the holding of liquid securities’… According to Keynes, the stock market is not simply an efficient way to raise capital and advance living standards, but can be likened to a casino or game of chance. “For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs–a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbor before the game is over, who secures a chair for himself when the music stops.”

Instead of placing finance on a proper foundation of economics, Keynes grounded them both in psychology; arguing that the handling of money is a kind of neurosis. According to the definitive history of Keynes’ early intellectual circle, The Cambridge Apostles: